01 September 2010

Investment Thesis. The quarter was largely inline with updated expectations in terms of the bottom-line number and key themes.

Domestic Retail turned in another good quarter despite softer margins on good volumes and improving credit. Overall, credit came on much better than expected. Wholesale was soft, but not materially disappointing relative to reduced expectations. To us, International had a decent quarter and continued to earn through some headwinds reasonably well.

From here, we expect growth in Domestic retail on modest volumes and improved credit, and better Wholesale on a potential bounce back in Trading. International remains the key variable in our view. We believe we have been conservative, but expect to see some improved trends in the coming quarters with the potential for a much stronger earnings contribution.

Scotia remains among the best positioned of any of the Canadian banks to capitalize on a recovery scenario in our view (i.e. superior growth in International, easing credit costs, a return of Business lending). Despite some strong recent performance, on our unchanged Target Price we see good upside. Reiterate Buy.

Reaction to Q3/10 Results. There appeared to be very little to get overly worried or excited about in Scotia’s results this quarter. Investors continue to note the strength of the volume trends in the bank’s Domestic Retail operations, having been among the best in the group for the last 2-3 quarters. However, the notable down tick in margins is somewhat worrisome (more on that below).

There was a fairly muted response in the stock initially, but it closed the day down just over 1% amid a mixed tape for the Canadian banks.

Better than expected credit trends were encouraging, relative to concerns that Scotia’s PCLs might run higher for longer, given the bank’s International and Commercial/Business focus. However, improving credit has really ceased to be much of a catalyst for higher expectations.

The wildcard in our view, and in the view of many clients, continues to be International. Through some noise on the quarter, the bottom-line result seems to have been largely inline with broad expectations (it was better than our number) and it is encouraging that the segment can continue to earn through some headwinds.

However, underlying volume trends (to the extent they can be deciphered) appear to be fairly modest. This is not entirely surprising, and we still hold a fairly constructive outlook, but at this stage it does require some faith/optimism that trends will eventually pick-up; which we find some investors continue to doubt.

Key Issues

Time to worry about Domestic Retail trends? In looking across the Q3 results so far, the incremental news for us has been evidence of some slightly worse than expected pricing and competitive pressure in the domestic market as evidenced by the margin trends.

To us, certainly part of the pressure reflects the rate environment of low absolute rates, the compression in the Prime-BA spread on the quarter and the general strength in the mid-part of the yield curve.

However, against this backdrop, commentary suggests that the big wave of re-pricing has now largely washed through the results. Instead, we are now seeing an incremental increase in competitive activity, particularly in residential housing (both traditional mortgages and HELOC products). Likewise, the banks have stepped up competition in the deposit market.

At this stage, we do not see evidence of irrational behaviour (which tends to correct relatively quickly in any case). Although we had not factored into our numbers, we had previously noted the potential for margins to expand in a world of increasing reference rates. At this point, we are more inclined to say margins will be flat to up (very) slightly, with a lower probability of a notable up-tick from here.

Outlook

We have made next to no changes to our model. In our outlook for next year, we see earnings running north of C$1.10 per quarter as PCLs decline and International starts to show some modest acceleration (and even further acceleration heading into 2012).

Justification of Target Price

In determining our Target Price we establish a Fair Value P/BVPS multiple based on our expectations regarding long-term sustainable ROE, growth and COE. Our expectations currently stand at 17.5%, 4.5% and 10.0% respectively implying a Fair Value P/BVPS multiple on the order of 2.60x.

Key Risks to Target Price

1) The continued weakening of the U.S. dollar, 2) country and political risk in its international markets such as Mexico, 3) integration challenges associated with its recent and future acquisitions and 4) adverse changes in the credit markets, interest rates, economic growth or the competitive landscape.

Investment Conclusion

The bank basically delivered an in-line quarter consistent with the key Q3 themes to date with good Domestic, strong credit and softer Wholesale results. We see potential upside in International. Reiterate Buy.